Basic Money Management
What is the first rule of trading?
An effective money management strategy is an essential part of any trading system, and it can make the difference between one that lets you trade profitably, and one which erodes a traders capital until they can no longer trade at all.
In this post, we are going to explain why.
Rule one: Preservation of capital
The most important rule of trading is preservation of capital.
You may be thinking “But I thought it was to make money..” and if you are thinking that then you’d be wrong.
Making money from trading is certainly the objective of every trader, but the most important rule is to preserve your capital. You’re only a trader for as long as you have capital to trade with.
Unfortunately, greed and human nature being what it is this rule tends to be overlooked or ignored until after a trader has experienced a substantial drawdown, or a series of smaller drawdowns that has significantly eroded their capital.
One common mistake amongst traders is that they believe that if they were to lose 20% of their $20,000 bank, they only need to make back that 20% to bring them back to break even. That is wrong. In actual fact they need to make back 25%.
A 20% drawdown of $20,000 brings the bank account to $16,000, however a 20% gain on $16,000 only takes the bank account to $19,200. This is still $800 short since we have gained 20% of $16,000, not 20% of $20,000.
A 25% gain on $16,000 though brings the bank account to the original $20,000 and a break even position.
The following table may be of assistance to illustrate the point more clearly.
% Loss of capital - % needed to return to break even
10% - 11.11%
20% - 25%
30% - 42.86%
40% - 66.67%
50% - 100%
60% - 150%
70% - 233%
80% - 400%
90% - 900%
100% - Eroded bank
To put it another way, suppose a trader were to risk $2,000 of a $20,000 trading bank in a trade (certainly not something I’d recommend).
That risk represents 10% of the trading bank, and if lost, would bring their trading bank down to $18,000.
Now if the trader again risks $2,000 on their next trade, that would represent 11.11% of their remaining trading bank. Again, this is certainly not something I would recommend doing as chasing losses is a recipe for disaster.
Strict money management is crucial to the success of a trader. Even with an ordinary trading system, a trader can be successful and trade profitably providing good money management principles are applied.
For example, assume a trader is implementing a system that is successful 70% of the time. Even with such a high probability system, this trader will at some stage experience a run of continuous draw downs.
An effective money management strategy will ensure that a trader can recover from that situation.
The worst possible scenario, and many traders make this mistake is to double up their exposure after a losing trade. As I mentioned above, chasing losses is a recipe for disaster.
For example, let’s assume a trader risked $1,000 from a $20,000 trading bank, but instead of taking the loss chose to ‘roll out’ and double up instead. How many trade losses would it take to erode the bank? Less than you might think.
Trade # - Exposure
#1 - $1 000
#2 - $2 000
#3 - $4 000
#4 - $8 000
#5 - $16 000
#6 - Eroded bank
Losses are a part of trading and traders must be aware of them and protect their capital.
Every trader goes through a losing streak. By protecting their capital though, especially while learning the art of trading, they can recover and succeed.
Remember, preservation of capital is the primary objective, making money is secondary.
Happy Trading
Brian Dibbins
Elite Insiders Group - Trading Systems
Trade Profitably © 2006 - 2007
